Rebecca Hotsko (00:04:13):

I actually worked at the Bank of Canada for it was two years and I worked on the unconventional monetary policies in 2020 before I left. So it gave me a whole great insight of how they work, but it was only after working on it for two years did I really start to understand it. So it’s a big topic. I’m excited to dive in with you today on it. So just to start off and set the stage, can you explain to our listeners what conventional monetary policy is and what are the main tools the Fed can use to achieve its two-part mandate?

Alfonso Peccatiello (00:04:50):

It’s a very good place where to start, and while people that have been in markets are following markets for the last 15 years are basically used to one conventional monetary policy tool, which is the Fed funds, effectively, Federal funds rates. Actually, historically, the Federal Reserve had two conventional tools to try and drive their mandate achievement, which are the Federal funds rate, but most importantly, the open market operations, let’s say. So basically, the reward that they were giving banks or the price, let’s say, for bank reserves, the Eldon Bank reserves.

(00:05:26):

So first, we need to discuss that for a second. In an environment pre-great financial crisis, the amount of reserves in the system in the US was actually pretty, pretty low. We’re talking in the billions. While as everybody would know today, after the great financial crisis with many rounds of QE, the amount of excess reserves in the system is in the trillions. So we’re talking about different zeros less.

(00:05:48):

When basically there is an amount of reserves which is in the billions, effectively both by changing the reward that banks got on these reserves, effectively the central bank could steer short-term interest rates as well. Let me try and explain how that works. So try and effectively imagine that this bank reserves are nothing else than interbank money. So this is money that we can’t use. So we as the private sector cannot go and buy bread or a house with bank reserves, but banks can use and do use to transact between each other. I don’t know. JP Morgan can pay Goldman Sachs in bank reserves, for example.

(00:06:31):

Now, before the great financial crisis, as I said, basically the Federal Reserve tried to steer short-term interest rates by trying to adding and removing a specific amount of these interbank reserves. Generally, pretty small changes were enough and also trying to effectively lead in this way to supply a scarcer or less scarce supply of bank reserves that could drive as well the prevailing interest rate that banks were asking while lending these reserves to other banks.

(00:06:58):

Now, so lowering the supplier of reserves, basically the Fed would force financial institution to bid up the price of Fed funds, which are, again, the rate at which banks lend reserves to each other, and so they would get higher interest rates and vice versa in the very front end, and everything went pretty smooth because the amount of reserves in the system was limited and banks had an interest in getting these reserves because they could pay each other and settle against each other with these reserves, Rebecca.

(00:07:23):

Then after 2008, what happened was quantitative easing at a very large scale. Quantitative easing effectively is the process by which a central bank expands both the liability side of their balance sheet and the asset side of their balance sheet. While everybody talks about the asset side of the balance sheet, which is the result of central bank’s buying bonds basically from the private sector, also the liability side needs to increase. The resulting item that increases immediately is bank reserves. So effectively, the Federal Reserve, like any other central bank, can create bank reserves out of nowhere basically by typing electronically on a keyboard, and with these bank reserves can go and purchase government bonds from the private sector, be it banks, pension funds, households, whoever owns them, right?

(00:08:08):

Now, obviously, when you do that in a very large scale, it’s clear, Rebecca, that the amount of excess of bank reserves in the system goes up to a level that is just so large that effectively changing a little bit the amount of these reserves in the system with open market operations, it’s definitely not enough to control short-term interest rates because the supply of these reserves is so large and effectively moving a little bit the needle doesn’t really change the preference that banks have for having a certain amount of bank reserves and, therefore, influencing short-term interest rates.

(00:08:43):

That’s why effectively the Fed had to change a bit the dynamics by which they try and control short-term interest rates, and what they do today is instead they basically use Fed funds rate and interest on excess reserves. So they would effectively create a corridor, basically, where they try and control by a new mechanism directly what is the interest rate owned by banks in owning these excess reserves. That’s new mechanism. That’s the mechanism of controlling directly Fed funds rates rather than the small open market operations that could change all of a sudden the amount of bank reserves and the reward banks will get by having them because there are so many out there anyway that today it’s all about Fed funds rates.

Rebecca Hotsko (00:09:26):

So first jumping back, then on the unconventional side, you started to mention QE. So that’s the first unconventional monetary policy that we’ll be talking about today. So I think it would also just be helpful to take a little step back and just talk about why they have to resort these unconventional policies in times of crisis. Why can’t they just, I guess, use their conventional policies as well?

Alfonso Peccatiello (00:09:53):

Let’s say a conventional policy after the great financial prices, it’s very intuitive and it’s lowering interest rates where inflation is undershooting the central bank target or otherwise increasing it like it is today when inflation is overshooting the Federal funds or the Federal Reserve target. Now, one of the problems has been that central banks have undershop their target for basically a decade across the world. So of course, a clear example would be Japan, whose core inflation has been negative 0.2% for 20 years on average. So not only they have not reached their 2% target, but they haven’t even barely achieved any inflation at all or avoided deflation, which is a credit-based system is actually quite dangerous as a situation to be in. We can chat about that later.

(00:10:37):

Effectively, the point is that once you try and use all your conventional tools and still you don’t barely get there, let alone in inflation itself, not even in inflation expectations close to your target, you need to resort to new instruments, Rebecca, and that’s a matter of credibility. So I’m talking to central bankers around the world because of my previous job. You realize that one of their biggest incentive schemes is to make sure that their credibility is actually pretty high across market practitioners because anchoring inflation around 2% makes their job much easier in trying to achieve their target at the end of the day.

(00:11:14):

If people don’t believe that they’re able to get there, it’s going to be much harder, actually, to get there. So when you don’t get there, you resort to unconventional tools, and unconventional tools are basically stronger set of tools that would try and make you more credible in achieving your targets. Quantitative easing using has been the very first one used in large scale, first in Japan, then in the US, and then in Europe as well, than in the UK, then in basically every jurisdiction in the COVID crisis.

(00:11:44):

The reason why quantitative easing is really used is that in central bank in jargon, it helps the transmission mechanism of monetary policy. So how that works is if central banks buy government bonds from the private sector, they are effectively going and changing the composition of the portfolio of the private sector. So think about the pension fund, Rebecca, owning a bunch of government bonds and then equities credits and other risk assets to try and generate a certain return that they use to then be able to pay their pension contributions to their clients over the next 30 to 40 years.

(00:12:21):

Now, if the central bank unilaterally decides that this pension fund needs to have less bonds in their portfolio because they’re basically forcefully being taken away by a central bank that beats up the price until somebody in the private sector is forced to sell them the bonds, the pension fund will now have a portfolio composition, which is different. They will have equities, credits, bonds, but then less bonds than before and they will have instead bank deposits. So they will have a deposit at their bank they’re banking with. It could be JP Morgan, it could be Goldman.

(00:12:53):

Now, a pension fund, obviously, needs bonds, Rebecca. They need bonds for fixed income returns. They need bonds to hedge their liabilities because these liabilities are very long in time. They’re 30 years, 40 years. So a pension fund needs some fixed income exposure on the asset side to make sure that risk is somehow hedged. So once the central bank is effectively removing from the system on aggregate these bonds, at some point when volatility is suppressed, when the signaling mechanism of this quantitative easing works as well through the system so that volatility comes down and credit spreads start to tighten a bit, it’s very likely that over time the private sector actors will try and rebalance their portfolios. They will try and buy back those bonds. They will try and go after some very safe credits for some really good investment grade corporates because they need some fixed income exposure.

(00:13:46):

So you can imagine, you can start to picture how this portfolio rebalancing mechanism works and how this helps monetary authorities to have their transmission mechanism Fed into the economy because as these risk-free yields, basically, government bond yields, especially real yields start to mechanically drop as the central bank is effectively pinning the price of these government bonds to a certain level, there is over time a cascade effect into riskier asset class, first a safer part of the riskier asset class spectrum, which then feeds into riskier and riskier asset classes, which means capital effectively flows towards a broader sector of risk assets and, therefore, towards the private sector.

(00:14:26):

As credit flows there, the hope of central bankers is that this will stimulate economic growth, investment, et cetera, et cetera, and ultimately generate some inflationary pressures. This unconventional tool has been used pretty broadly. I guess listeners will be familiar with that.

Rebecca Hotsko (00:14:41):

I’m so glad that you touched on that because I think a lot of people are still maybe confused by how QE actually makes asset prices rise. You touched on both of the channels there. So there’s the portfolio rebalanced channel, where when the Fed starts buying, it pushes up the price and pushes down the yield so that investors have to now go into riskier assets because if you want to earn yield, do you have to go rebalance your portfolio maybe riskier than you would otherwise? Then the other part on equities, I guess it’s the two part is that by lowering the long-term government bond, that’s the discount rate for a lot of equities, and so it’s artificially propping up asset prices in that sense as well.

Alfonso Peccatiello (00:15:26):

Yes. That’s indeed the dual channel that basically works to actually pushing up asset prices, one should say first, and then central bankers hope that because of this lubrification of the credit channel mechanism effectively, then money will flow towards the private sector and, therefore, activity will pick up and, therefore, with a lag. Inflation and inflation expectation will trend towards their target again.

(00:15:51):

Now, there are caveats, of course, Rebecca, and the first one is that if you lower the price of safe assets, so let’s say government bonds, if you lower real yields there, risk-free real yields, it’s not automatic that risk assets will get a bid and will, of course, rally together with that. The reason why it’s not automatic is that the risk premia are the difference that actually needs to remain very narrow because there have been periods in the past where government bonds didn’t yield much in real terms, but people were very scared about a recession and earning slow down, labor market weakness and, therefore, they would be very hesitant in actually buying risk assets, equities or credits, for example, despite very low level of real yields in the government bond space.

(00:16:40):

So one of the main channels, I think, and objectives of the central banks when doing QE, rather than lowering real yields per se straight away is actually to suppress volatility. So I want to make sure that this message comes across because when volatility is actually suppressed for a while, the way investors behave is at the very beginning, Rebecca, they might be scared. Think about March 2020, April 2020. There is a big pandemic. There is a lot of uncertainty, and the Federal Reserve is coming in buying 500 billion treasuries a month or whatever the number was in April. It was gigantic, right?

(00:17:15):

It wasn’t immediately automatic that people would say, “Okay. Let’s go and buy some junk corporate that straightaway. Let’s go and buy the frothiest and most leveraged stocks out there.” It didn’t really work this way. The way it worked is, okay, so the Fed is backstopping the safest, most liquid asset class in the world and it’s backstopping the repo market, underpinning it. It’s backstopping the liquidity and the functioning of the treasury market. Okay, good, at least we know that. They can do that pretty much at infinite amounts because they directly control and directly purchase these treasuries as we discussed, and their balance sheet is infinite. So you as an investor can only try and be against that trend, but your balance sheet and your risk ability to go against the Fed is limited by definition because your balance sheet and your risk will not be unlimited to one from the central bank. Theoretically, it is unlimited.

(00:18:09):

We know that that functions. After that, what people will be looking at is, “Okay. So what is now an asset that I would want to own in an environment where the economy is completely shut, but I got some support from a central bank which is backstopping the treasury market?” The answer is nothing, still nothing because I don’t have any visibility on what the cash flows will be. I don’t know if volatility will be high or low. I have no idea. So for a while, actually, the objective of the central bank is not to make credit directly, money directly flow towards the riskier spectrum of risk assets, but it’s rather to suppress volatility.

(00:18:44):

Once this volatility is suppressed for long enough, and once the system is flooded with reserves, and once these government bonds are taken away from portfolios for a long period of time, which can be a month or three months or six months, at some point, a combination of this portfolio rebalancing effect, lower discounting rates, and most importantly lower volatility for a longer period of time will ultimately drive investors to try and seek some risks in that portfolio, especially if the economy is also collaborating. That’s the entire setup that you need to make sure that these unconventional monetary policy tools work. In the past, the track record has been pretty good on asset prices, pretty mixed on helping central banks achieving their inflation targets.

Rebecca Hotsko (00:19:30):

I read an interesting article. I remember this back in 2020 and I went and found it for this interview and it said that without the Fed conducting QE, the stock market should actually be trading closer to 1800 rather than 3300 that it was trading at the time, and the NASDAQ should have been closer to 5,000 rather than the 11,000 it was trading. This is because, like we were talking about the financial crisis where the Fed, their monetary policy actions propped up asset prices that much, it just makes me wonder now that we’ve gone from billions of QE to trillions, what level the S&P should be at now. Do you have any thoughts on that?

Alfonso Peccatiello (00:20:13):

The very tight relationship that’s been drawn and actually used as a reference many times between the Federal Reserve balance sheet and S&P 500, let’s say, it’s a relationship that has some truth in it, but also must be taken with a pinch of salt, and let’s discuss that for a second. So first of all, it’s not about the Fed balance sheet, but it’s mostly about one item of the Fed balance sheet, which is the amount of bank reserves because while on the asset side the Federal Reserve today mostly owns government bonds as part of its asset side, on the liability side, there are actually three drivers of the Federal Reserve liability side, which are the bank reserves, the treasury general account, and today, the reverse repo facility, which is over two trillion dollars. It’s a very large driver of the liability side of the central bank.

(00:21:02):

Now, not all these drivers act the same way because the treasury general account and the reserve repo facility, those two items can be actually pretty volatile. So the government can draw down their treasury general account at the Fed and decide to spend money in the real economy or it can pump it up, but it will be very cyclical and generally a mean reversing process. So the government uses the treasury general account as a liquidity buffer, basically, when it decides to top it up or to actually top it down and spend it in the real economy, but, Rebecca, it would generally be a mean reversion amount, right? So it contributes cyclically to a higher or lower Federal Reserve balance sheet, but not that much over the very long term.

(00:21:41):

The reserve repo facility, again, it’s basically a new tool that the Fed has created to make sure during the pandemic that T-bills didn’t yield negative yields. That’s the very reason for it. Where Fed funds were at 0%, there was a large amount of excess reserves in the system. Actually, there was an incentive to try and park the success reserves into short-term instruments, and many of the money market funds actually out there don’t have an alternative when it comes to their mandate. They can’t buy high yield. They can’t buy investment grade bonds. They can’t buy equities. They are basically forced by mandate to stay invested in very liquid short-term government bonds.

(00:22:21):

As there was not much supply of these government bonds, obviously, the supply-demand picture was so skewed that as money market funds didn’t have access to the Fed, they couldn’t park money directly to the Fed. They were rushing into buying these T-bills, and as all of them were buying these T-bills, the yield was threatening to go negative, and the Federal Reserve didn’t want to lose control of the short term of the interest rate market and, therefore, effectively set up this facility to make sure that the money, effectively, the excess liquidity in the money market fund industry could flow into a facility where the Federal Reserve provided an access effectively to their liability side. The money market funds would have an asset to invest in which wasn’t T-bills, basically. It would fit their mandate as well.

(00:23:07):

Now, again, this is a large contributor of the Federal Reserve balance sheet and the swings can be pretty large, but you can imagine that over time the Federal Reserve would have an incentive to actually make sure that this facility is thrown down. So as long as T-bills are issued into the market and excess liquidity goes down, money market funds will fund back their investments, their typical investment pattern into T-bills.

(00:23:30):

We are left with the third side of the liability of the Federal Reserve balance sheet, which is bank reserves, and bank reserves are the most relevant of the three items because, effectively, the Federal Reserve decides how many bank reserves are in the system at any point in time. A single bank decides whether they want to have these reserves, whether they want to have more of these reserves, whether they want to lend them away or they want to get some more reserves on their balance sheet, but in aggregate, in the banking system, basically, the Federal Reserve decides how many reserves are out there.

(00:24:02):

The relationship between bank reserves and the S&P 500 is one we can discuss about. Again, people are used to seeing bank reserves going up, the S&P going up, and therefore they also assume if bank reserves are going down, the S&P is supposed to go down like we are seeing. If you think about the portfolio rebalancing effect of a bank, a bank can own bank reserves, they are allowed to do that. They can own bonds. They can own investment grade bonds, mortgage-backed securities in their portfolios, and that’s pretty much it. Equities are a non-regulatory friendly item for banks. They can own pretty little of that under regulation in their liquidity buffer. It’s mostly about government bonds, corporate bonds, well-rated corporate bonds, and mortgage-backed securities, and bank reserves.

(00:24:49):

The story goes as well that if you pump more bank reserves into the system, the aggregate banking sector will have to have more of these reserves. As over time, these reserves become way too much. At some point, banks will decide to rebalance their portfolios and go and buy more corporate bonds, more mortgage-backed securities. They would extend into the riskier side of the regulatory allowed asset classes they can touch, basically, in their liquidity buffers.

(00:25:15):

I have to say that this is basically what happens. I’ve worked in a bank for a pretty long time and if you effectively leave this process and checked a lower volatility for a long enough period of time, ultimately, also banks will start to take more risks with their liquidity buffer. Again, it’s not an automatic thing because if risk managers are not happy with you taking a larger amount of risk in a certain corporate bond segmented market, they wouldn’t allow you to do that anyway, regardless of how many bank reserves are there, Rebecca.

(00:25:44):

If banks would then beat up these corporate bonds, spreads will tight, and that will make equities more attractive against corporate bonds. So a global macro manager that is looking at all asset classes in the world will see that corporate spreads are very, very tight because maybe banks are beating those up, while equities are very cheap against those and it will be inclined to rather purchase equities than corporate bonds and again, the portfolio rebalancing effect will work.

(00:26:09):

Bank reserves are a good indicator, especially the rate of change of bank reserves is a good indicator of whether banks will be more or less inclined to take additional risks with their liquidity portfolios, but again, it needs to be analyzed within a context and it can’t just be drawn with a single line against the S&P and assume that it will just keep track of it.

Rebecca Hotsko (00:26:30):

That’s super interesting because I always read articles that relate it to the total Fed balance sheet, not just that one specific segment of it. So that’s really interesting. So what is it saying right now then?

Alfonso Peccatiello (00:26:44):

Yes. So the amount of bank reserves is falling very, very quickly and, effectively, the reason is twofold, if you wish. The first is the most important and long-term one that’s focused on that is that the Federal Reserve is going through quantitative tightening. So quantitative tightening is the reverse process of quantitative easing by which in a passive quantitative titling, which is what the Fed is doing, which means the Fed doesn’t sell actively bonds to the market, but the Fed just doesn’t reinvest some maturing items on their balance sheet, just basically decide not to reinvest those amounts, what happens is that does the Federal Reserve automatically shrinks the asset side of the balance sheet by not reinvesting these maturities. Also, the liability side of the balance sheet of the Fed needs to shrink, Rebecca, right?

(00:27:30):

So as we discussed, there are three items by which this can happen nowadays, the treasury general account, reverse repo facility or bank reserves. So far this year, bank reserves have taken the brand for this decline. Now, we could talk about why reserve repo and DGA influenced that, but over the medium term, what’s important for people to understand is that as the Fed will be doing more quantitative tightening, and we’re talking about roughly 90, 95 billion dollars a month, that’s the target, the Federal Reserve effectively intends to shrink the asset side by one trillion a year, roughly, something like that. One trillion is a pretty large amount, and it will result in roughly one trillion bank reserve less.

(00:28:13):

Now, the reserve repo facility, the treasury general account could offset some of that, but the trend will probably remain, Rebecca, that bank reserves will be falling. So the rate of change of bank reserves will actually be negative, and that means that commercial banks will have their portfolios rebalanced in the opposite way. They will now have less bank reserves, which are a zero duration, zero credit risk, a very liquid regulatory friendly form of liquidity. Banks can lend these against each other. They can settle payments with these against each other. They don’t have any credit risk, any capital attached to that. It’s basically a deposit at the Federal Reserve, if you wish.

(00:28:56):

They will have, Rebecca, less of those, forcefully less of those because the Fed is removing those from the system, which means the portfolio of a bank treasury department will at some point look like something that has an amount of bonds and then has an amount of corporate bonds, an amount of mortgage-backed securities and less safe, very safe and liquid short duration assets. So you can imagine that the bank treasury will over time be less inclined to take additional marginal risks out there, but also in general, let’s not forget that the government of the United States will keep issuing bonds in the meantime. So there is one of the marginal buyers out there is actually not buying treasuries anymore.

(00:29:37):

Basically, the private sectors now will be asked to step up and absorb more of the issuance coming from the government. Banks, obviously, act as a very large buyer of treasuries, but if they’re very safe asset, the reserves are actually shrinking, and at the same time, they’re asked to actually step up as part of the private sector and absorb more government issuance coming their way. You can imagine, Rebecca, that their clearing level, their reservation price basically to absorb more of these bonds will have to change over time, especially if those bonds are risky, especially if it’s a corporate bond, especially if it’s a mortgage-backed security. They will be a bit more reluctant to absorb those, which is exactly what we are seeing and it’s one of the reasons why credit spreads have widen and one of the reasons why mortgage-backed securities are actually being hit pretty hard. The Fed isn’t selling those, but the Fed is reducing the amount of excess reserves in the system and the private sector is asked to step up and buy more exactly at the same time, which is quite a combination, I think.

Rebecca Hotsko (00:30:40):

I’m glad you mentioned that because I want to get into the impacts of the Fed reducing its balance sheet. So like you mentioned, since September, they started rolling off 95 billion every 30 days, I believe. So you mentioned some of the impacts of this shrinking balance sheet, but can you talk about, I guess, how that impacts interest rates? I read an article that said 30-year fixed mortgage rates reached 6.12% and in part due to the shrinking balance sheet. Can you talk about that link? I think that’s often misunderstood.

Alfonso Peccatiello (00:31:18):

You’re right, Rebecca. So one of the most common misconceptions out there is that when the Federal Reserve does quantitative tightening, yields are going to skyrocket, and that’s because, basically, the Fed isn’t buying bonds and the private sector is asked to buy more bonds at the same time. So it must be that long-term yields have to go up to actually have a clearing price that makes everybody happy.

(00:31:41):

Now, while there is a temporary truth to that because as we discussed the private sector all of a sudden is asked to absorb more bonds, that’s correct. With less reserves in the system, indeed that’s the case. Now, let’s talk about what a quantitative tightening process from the Federal Reserve does to the macro picture out there.

(00:32:01):

So when you have a central bank that is effectively doing quantitative tightening, what they’re trying to do is, literally, they’re trying to slow down the economy. There is no other way to sugarcoat it, but the way it works is that they will make effectively credit more difficult to flow towards the private sector. Think about it as the opposite of the quantitative easing mechanism we talked about that lubricates the credit creation in the private sector. Quantitative tightening will be the opposite, will basically make sure that credit flowing to the private sector becomes more expensive, more difficult to get.

(00:32:31):

Basically, the Federal reserve or central bank wants the economy to slow down. Now, think about 30-year bond yields. What are those from a macro perspective? They can be decomposed into the expectations of long-term potential growth rates, real growth rates of an economy, and long-term expectations for inflation that an economy will be able to generate together with something called term premium, which we can quickly define.

(00:32:58):

Now, think with me. If the central bank is slowing down the economy today, is making sure that the flow of credit actually slows down pretty materially, what is central bank doing actually to this long-term growth and inflation expectations? It’s actually hurting them. It’s making sure that growth over the medium to long term will have to decline. Also, it’s making sure that inflation, so basically nominal growth, will have to slow down to make sure that the Federal Reserve can have a more balanced labor market, et cetera, et cetera. It’s a situation we are in today, by the way, where Powell has been very clear that he wants the economy to slow down so that he can actually slow wage growth and inflation down as well.

(00:33:38):

That means that, basically, anything left and change apart from that, yields are supposed to go down as a result of quantitative tightening, very long term yields because perspective for long-term real growth and inflation are being reduced by the activity of quantitative tightening of the central bank. There is term premium component, which basically would be the premium that investor require to buy 30-year bonds rather than to buy a three-month T-bill and roll it over every three months for the next 30 years.

(00:34:08):

Now, the premium that investor require to effectively lock in a 30-year bond today would be pretty difficult to model, but let’s leave that side of the equation out. Just I invite you to think about the fact that if a central bank is slowing the economy down directly via quantitative tightening, it needs to be reflected in long-term inflation and growth expectations which are down, and on top of that, 30-year bond deals are much beyond control of a central bank compared to front and interest rates.

(00:34:36):

One of the reasons is that the very trend for long-term potential growth, it’s not in the hands of central banks. If you think of an economy, Rebecca, long-term potential real growth is nothing else than the sum of the growth in labor supply and the growth in total factor productivity. It’s how many people actually actively work and contribute to economic growth. That’s labor growth, labor supply growth of the long term, which is a byproduct of demographics. The other thing is how productive these people are and how productive is the capital allocation we do, we put through our economy.

(00:35:13):

If I look at the US but also Europe, Japan, UK, any place in the world, China included, labor force growth, wow, that’s something we need to discuss. I mean, the Chinese labor force will shrink by hundreds of millions of people, which is an impressive number over the next 20 to 30 years. Simply as people age, they become older and we haven’t had enough kids, basically, over the last 10 to 20 years to replace these people that are retiring. The amount of people in the labor force will be lower than it was 20 years ago. So the growth of the labor supply will be negative in Europe, will be negative in China, will be negative in Japan, will be just flat in the US, thanks to the fact that net immigration is pretty strong.

(00:35:56):

That’s also the reason why Canada is very keen in having positive net immigration numbers. It’s because they effectively see this replacement necessary to keep the labor force growth at least flat, but flat isn’t a good number when it comes to long-term economic growth. Then you have to think about productivity, which has been declining. So it means productivity is still positive. Of course, we grow our productivity levels in general, but the growth in productivity is actually stagnated to levels roughly 0.51% area of additional productivity per year.

(00:36:27):

The Federal Reserve doesn’t have a direct impact on productivity, even less of a direct impact on demographics, which if you think about it, makes the case for long-term economic growth and long-term inflation expectation to be already on a declining trend, and quantitative tightening just compounds that problem by slowing down the economy in the short term even further.

(00:36:50):

Counterintuitively, quantitative tightening over the medium term leads to lower long-term bond deals, and quantitative easing on the other hand can lead to higher long-term bond yields because it can boost expectations for growth. It can boost expectations for inflation. It’s pretty counterintuitive, but actually, it’s also empirical evidence.

Rebecca Hotsko (00:37:11):

That’s so interesting. I want to unpack a few things there because I want to bring this back to the stock market impacts first. So quantitative easing, we talked about the channels that it props up asset prices. So then quantitative tightening, should we expect a similar asset like decline in stock prices then? Is that why the stock market reacts so negatively to these, the news of quantitative tightening, because it’s the reverse?

Alfonso Peccatiello (00:37:37):

Yeah. So when it comes to quantitative tightening and stock prices, we discussed about the fact that quantitative tightening will reduce the amount of bank reserves in the system. So the interbank liquidity will basically go down and that should lead to banks being much more reluctant in taking risks and, therefore, equity valuations could be hit by that. That’s one part of the story.

(00:37:57):

The second one, Rebecca, is that we so far discussed about the money that banks use and that’s bank reserves, but what about the money we use? So the money we use is not bank reserves, we said it before, and it’s not really cash nowadays. Cash only accounts for 3% of transactions and volume of private sector transactions in general in advanced economies. 97% is bank deposits. So it’s basically transferring digits from a bank account to another bank account at the end of the day. That’s 97% of the money that the private sector uses.

(00:38:33):

Now, I actually created a metric that tracks the rate of change of the bank deposits, so the money that we use, in the non-financial private sector in the five largest economies in the world. So I think we’ll basically track the amount of bank deposits sitting on our balance sheet, Rebecca, on corporate balance sheet, mostly. Those are private sector entities that drive economic growth. They drive real economy activity, right?

(00:38:59):

If you look at the rate of change in this bank deposits, basically, that’s the money for the private sector, if you wish, not a bank deposit owned by a pension fund, not a bank deposit owned by PIMCO. They cannot spend it on bread. They cannot spend it on a computer. They can only, again, buy an asset with it, but you or I, a corporate, we can make investments. We can do proper spending. So if we track the amount of money for the real economy actors for the private sector, we track the rate of change of those amongst the five largest economies in the world. That metric I created is declining at the fastest pace in decades.

(00:39:36):

So the rate of change is very, very negative, and it’s simply the byproduct of the fact that governments have injected a large, gigantic amount of private sector money in 2020 and 2021 via fiscal transfers. Basically, the government has increased the amount of money, spendable money, inflationary money that we own, not bank reserves. They’ve also increased that, but that’s been the central bank. I’m talking about our money. The rate of change has been so positive that simply, mechanically speaking, Rebecca, unless the government would repeat the same operation or banks will start lending all over the place, the rate of change in 2022 will be very negative because there has been no incremental fiscal spending at all.

(00:40:19):

On the other hand, actually, there has been some fiscal tightness. See, the tax season in the US was massively positive, which means that the government is taking money away from the private sector. It’s increasing its tax base. We as the private sector are getting less incremental money. The rate of change in the private sector money across the five largest economies in the world is actually really, really negative. So the combination of drop in interbank money, which drives appetite in taking risks, basically, starting from bank and then through portfolio rebalancing effect to other financial actors, summed with the fact that private sector money, the rate of change of this private sector money has also declined very materially is basically setting the stage for the worst possible setup for risk assets out there because real economic activity will obviously fall if the private sector has less money, spendable money at disposal, and at the same time financial economic activity, let me call it like that, so the risk sentiment, basically, the animal spirits in markets, the valuation side of the stock market, total return will also take a hit, and that’s exactly what we are seeing happening in 2022.

Rebecca Hotsko (00:41:31):

Wow, that’s so interesting. So it’s basically the five largest economies you said are in the worst possible situation right now. I’m wondering, the Fed, we talked about how they’re reducing their balance sheet now. They upped the amount that they’re selling or rolling off their balance sheet, but a lot can change then, and the Fed has done this in the past where in the past crisis like 2008, 2009, they had to stop tightening because the financial markets couldn’t handle it. So I’m just wondering what would cause the Fed to abort their mission and maybe go back to easing.

Alfonso Peccatiello (00:42:11):

I actually published an article on my newsletter, The Macro Compass, I think it was in July, where everybody was very excited about the pivot. The article was called Fed Pivot My Alf. Let’s say my alf. It wasn’t really my alf, but you get the message. The point was that you need to understand incentive scheme of central bankers here, Rebecca. Powell, I think, since December actually, tried to convey the message that inflation and inflation expectations, he didn’t really like those and the trend that they were having, very upwards, very uncontrollable, and he was very keen in making sure that markets understood that his main objective is credibility in achieving his inflation target, and if inflation expectation are north of 3% and realize the inflation is 9%, obviously, he’s not credible. He needs to regain that credibility.

(00:43:04):

Now, obviously, there are tradeoffs and people are used to see these tradeoffs play out, and you mentioned a couple of those. The 2008 crisis you mentioned. One can mention 2018, very recent episode, where the Federal Reserve was tightening, tightening, tightening, and then at some point something broke in the equity market. We had a very large drawdown of 20% and Powell pivoted straight away in January 2019. This time, now I’m going to use a very expensive set of words in finance, which is this time is different.

(00:43:33):

Now, this time is different in this case only refers to the incentive scheme that Powell has in front of him, which is a complete risk of loss of credibility, total loss of credibility in achieving his inflation target, which as we discussed before, credibility eased the strongest asset of a central bank, and he needs to regain that credibility. I’ve talked to many central bankers in the past and they really hate situations where they lose control. A central banker wants to make sure that he can keep things within a controllable framework. So let’s say if inflation expectation are anywhere between one and three percent, yeah, if they’re 3%, okay, it needs to tighten a bit, if they’re 1%, it needs to ease a bit, but if inflation expectation are 0% or 4%, then the situation becomes much more complex and the reaction function of a central bank is not linear anymore.

(00:44:22):

They have to put themself in front of markets and say, “Hey, guys. We will make sure that inflation is at our target and trust us it will be enough,” and that’s exactly the words that Powell used in this last press conference. Trust me, the hiking path will go and proceed with will be enough to restore credibility and inflation. Now, that means that the tradeoff between Powell being very firm on that part of his mandate and keeping policy tight against breaking something, whatever it is, Rebecca, the labor market, the stock market, whatever, the credit market. This time, the tradeoff is very, very skewed towards Powell keeping a tight policy until something extremely serious happens.

(00:45:07):

A 20% drawdown in the equity market does not fall into the category of extremely serious happens. Now, 32 trillion dollars have been wiped out in wealth from global portfolios, liquid assets only I’m talking about, and the real estate market will probably have to decline a bit from here too on top of that. That seems like a gigantic amount, but that only sets us back to roughly summer of 2020. So that only takes us back off the excess, basically, and the animal spirits and the reopening effects that we have seen post-pandemic, but inflation is still extremely high way beyond any comfortable level for the Federal Reserve, which means that they will keep up at it until the job is done.

(00:45:51):

They’re also very honest, I should say, to a certain extent by saying, and I’m quoting Powell in the Jackson Hole speech that the household sector will need to go through some unfortunate pain. Those are the unfortunate consequences of having to slow down inflation. Those are Powell’s word and not mine, which I think are very, very loud and clear.

Rebecca Hotsko (00:46:11):

Yeah. I’m glad you mentioned all that, and that maybe seems it’s so relevant today and I asked that because of what’s happening with the Bank of England right now, how they pivoted and I was hoping that you could talk about that a little bit because it set off a warning signal if they’re doing that so quickly, will other countries, will other central banks have to do that as well? Can you talk a bit about what’s going on there?

Alfonso Peccatiello (00:46:35):

Yeah. So that was a pretty serious event. It’s a bit technical, but I think we can try and simplify it for the audience and make it clear. So what happened there was the following. The United Kingdom is a place that is extremely dependent from the outside world and it is when it comes to goods and services and it is when it comes to funding, to financial funding. The way you can see that, Rebecca, is in the fact that current account deficits are a common place in the UK. So the UK basically imports goods and services more than it exports to the world, so it is dependent on net imports from the world of goods and services. On top of that, it has an extremely negative financial account balance, which can be summarized into the net international investment position as percentage of GDP, which is nothing else than a measure of how much a country owes or actually lends to the rest of the world when it comes to financial accounts, right?

(00:47:28):

So the UK basically requires external financial funding from the world to support their deficits, basically speaking. Okay. So they have two deficits. They have a current account deficit. They have a financial account deficit, if you wish. They now have an inflation problem as any other jurisdiction in the world, but they start from a relatively weak setup of twin deficits, basically. On top of that, they just set a government that decided to add a third deficit into that, which is a fiscal deficit. So they went with a program, which was a fiscal largest announcement, basically.

(00:47:59):

Right now, when you have an exogenous shock with energy imports that are becoming more expensive, you have an inflation problem, then you have a financial account deficit, then you have a fiscal deficit, I’m sorry, but the market had enough of it and just went after both the sterling and the UK bond market, which is a typical reaction of market going after an emerging market setup, basically, where they basically say, “Guys, we are not going to fund you anymore unless you give us a much weaker currency to make it more palatable for us to invest in the UK. We need a weaker sterling, so we’re going to force it into you or alternatively, if bond yields are much higher.” So we need some compensation actually to fund the UK’s external deficit position, and that’s what was going on.

(00:48:44):

So of course, their central banks are the only entity left to try and stem that and what they can do is to say, “Okay. We hear you. We’re going to try and protect the currency if we want to fight you or we’re going to try and give you some higher yield. So we are literally going to raise interest rates in the UK to make it at least palatable for you guys to keep money invested in the UK.” That was the Bank of England plan to raise interest rates not because they wouldn’t want to defend the currency, but because they couldn’t. The amount of foreign exchange reserves held by the UK is extremely low. The UK’s dollar liabilities, foreign currency liabilities, both in goods and services but also in financial account, Rebecca, but it doesn’t have dollar assets, net dollar assets to defend their currency because, of course, they could sell those and buy back the sterling and try to push it up, but they don’t have that.

(00:49:34):

Switzerland has a lot of those. Japan has quite a lot of those. China has quite a lot of those. The UK doesn’t. So at that point, it ultimately was to raise interest rates solely, and I’m going to stop here because I see you want to ask a question.

Rebecca Hotsko (00:49:46):

Yeah. I just want to clarify. So that wouldn’t potentially happen in the US or it would be unlikely because we don’t have the same issue. In the US, they’re not lacking those assets to make up the foreign reserves.

Alfonso Peccatiello (00:50:01):

Now, the interesting thing about the US is that the US is required to export dollars abroad. The system is a dollar-centric system, Rebecca, where all the global trades, all the global goods and services transactions that happen around the world, all the commodities trades, all the dollar, all the foreign-denominated, that issuance, it’s all denominated in dollars. So the US is literally required by the global setup we have to export the global reserve currency. The US owns the denominator of the problem. The US basically has issues. The denominator that is used to transact in goods, in services, in commodities is used to issue and denominate foreign debt.

(00:50:50):

So the US is in the opposite situation. They do have current account deficits and the fiscal deficits and a negative net international investment position by design. That’s because the world, basically, has decided to trust the US with the global reserve currency, which is the underlying denominator of everything else that goes on in the world. So the setup is relatively similar when it comes to the fundamentals, basically. So current account deficits, net international investment position, fiscal deficits, all of those are true for the US too, but that’s because the world asks.

(00:51:25):

The world is based on this dollar exporting system where everybody needs a common denominator to have all these goods and trades and that issuance going on, and the US issues the denominator. The sterling doesn’t issue the denominator of all of that. The sterling literally just needs foreign funding coming into the UK. They need foreign good and services coming into the UK. They don’t provide a service to the world by effectively issuing the reserve currency of the world. So that is quite a vital difference to understand why the UK was really vulnerable while the US instead is in a different situation from that perspective.

Rebecca Hotsko (00:52:02):

Let’s talk a little bit about the recent strength in the US dollar. Can you explain what’s all at play there and then what would maybe cause it to break eventually?

Alfonso Peccatiello (00:52:13):

The dollar strength is the byproduct of the dollar being the denominator of the problem, let’s say. So let me try and specify. So let’s say you are a Brazilian corporate and you basically export commodities or any other goods and services to the world, and you operate, and you have a balance sheet, and you want some leverage because you think that through some leverage you will be able to expand your operations profitably or you will achieve a nice return on equity, you will use leverage, et cetera, et cetera. Okay.

(00:52:42):

Now, because the dollar is the denominator of your exports and trades, you probably will want to have some of these issuances well done in dollars, right? So you will want to issue dollar bonds. You will want to get your dollar funding, so you can use these dollars to basically keep and enhance this business model based on exporting goods and services denominated in dollars. Okay. Good.

(00:53:06):

So you in times where global trades are actually growing and economic growth is actually nice, Rebecca, what happens is that this will work fine because your liabilities will be denominated in dollars, but you will be getting plenty of dollars in because you will be selling those goods and services, and foreign trades will be picking up, and that’s so fine and dandy, right? Nice.

(00:53:25):

Okay. What happens when economic growth slows down? That’s basically what’s been happening over the last nine to 10 months by virtue of central banks trying, literally trying to slow economic growth down to achieve their inflation target is that your global trades and growth will actually slow down, which means you’ll be getting less dollars from the asset side of your balance sheet. From the income, you will be getting less dollars.

(00:53:47):

Now, you need to pay dollar coupons and you need to service dollar liabilities, but you have less dollar income coming through. So what you will be doing is you have a problem denominated in dollars. That’s what you have. You have a problem denominated in dollars. Okay. So at that point, the first reaction will be to try and get some hands on some dollars, literally. Okay. Let’s try and extinguish some of these liabilities, get some hands on dollar cash so that we can repay some dollar liabilities.

(00:54:15):

Now, you don’t want that dollar liability problem, which can become bigger and bigger as the dollar appreciates. You want to try and get ahead of that problem by basically getting your hands on dollars that will allow to extinguish the dollar liabilities. So even if the dollar income dries up, you have at least have solved your problem on the dollar liabilities, and that’s a dash for the dollar. So that helps, basically, the dollar appreciate because the deleveraging, so people trying to get themselves ahead of the problem, a problem denominated in dollar, when there’s a deleveraging, the denominator of the very leverage that we built, a leverage of commodities, trade and exports and that issuance, the very denominator tends to appreciate because the problem is denominated in dollars.

(00:55:01):

That’s right now what we are seeing. We are seeing a deleveraging in the Chinese real estate market, which is the biggest asset class in the world. The biggest single asset class in the world is getting slaughtered, basically, because of China deciding that there is a policy that needs to be applied. We’re seeing global growth slowing down. So all emerging markets leveraging dollars that do not have enough strong dollar income actually right now are having a little bit of a problem of dollar leverage. Corporates, which are leveraging dollars, when global growth slows down and the Federal Reserve tightens monetary policy, a system which is based and leveraged on the dollars of the global reserve currency will actually see the dollar appreciate.

Rebecca Hotsko (00:55:43):

That was super, super helpful. What would cause it to turn course? Would it be when the Fed starts to ease again when they pivot back?

Alfonso Peccatiello (00:55:53):

Yeah. So that would be one clear trigger. You’re right, Rebecca. So historically, the dollar tends to weaken when either economic growth is picking up. So if we get a good pickup in economic growth and, obviously, this deleveraging is not necessary anymore because all this companies leveraged in dollars and countries leveraged to the dollar will actually see good economic growth, good dollar inflows, and that mechanism that we discuss will actually not be there anymore. So that’s one reason why the dollar would depreciate because the dash for dollar cash would actually stop.

(00:56:23):

The second would be, and can be also a coincidental one, it could be that the Federal Reserve decides actually to stop tightening. So even to reduce the pace of tightening because, obviously, markets are forward looking. So the Federal Reserve has now made sure that the bond market reflects quite some forward tightening from their perspective. So the bond market is pricing Fed funds to be at four and a half percent next year. Even before the Fed gets there, the very fact that the bond market is already being priced in that very consistently, Rebecca, is then reflected into the private sector because we borrow based on these rates, which are basically already reflecting the Fed funds rate at four and a half percent in one or two years from now.

(00:57:03):

It would only require the Federal Reserve to announce they will do a little bit less than what’s already priced to basically depreciate the dollar because there is less tightening to be priced in all of a sudden, right? It’s a Federal Reserve, not necessarily a pivot straightaway, but also a reduction of the tightening signal to market would be enough. Ultimately, it’s all about inflation slowing down. That’s really what it is. If inflation slows down, Rebecca, the Fed doesn’t need to push this hard, doesn’t need to ignore all the tradeoffs that we are seeing, doesn’t need to break the labor market. If inflation is slowing down, the dollar will be coming down cause the Fed will be seen to be credibly less aggressive than it is today.

Rebecca Hotsko (00:57:47):

Then the last couple things I want to ask you, what do you think the impact of this strong US dollar is on earnings in corporate profits?

Alfonso Peccatiello (00:57:55):

Good question, and I run an analysis on The Macro Compass where I showed that a fast appreciation in the dollar actually leads to weaker earnings in the US, and there is very simple reason for that. If you look at the amount of sales and revenues that US companies are generating from abroad, so not in the US, it’s as high as 30 to 40 percent of the revenues and sales. It’s pretty large because US corporates are mostly multinational, so they have a very large presence abroad.

(00:58:23):

So clearly, if dollar appreciates, it tends to weaken the foreign earnings they’re able to do because simply their domestic currency is much stronger than it was before. So on a year on year comparison, earnings will be mechanically slowing down. An appreciating dollar actually acts as a headwind for most of these multinational US corporates that are generating profits abroad, and they are a pretty significant portion of the earning per share in the S&P 500.

Rebecca Hotsko (00:58:51):

Then what about the global impacts or exchange rate vulnerabilities of the dollar? I know you also wrote a great article on this recently.

Alfonso Peccatiello (00:59:01):

When it comes to other exchange rates against the dollar, I mean, right now, it’s mostly, I have to say, a broader risk sentiment story and it’s mostly what central banks will be doing to try and regain credibility on their effects perspective. So in the article I wrote, you can see that I use six indicators to try and understand whether, first of all, a country is well-equipped when it comes to fundamentals to deal with this, and second, whether their policy makers are well-equipped to deal with this. A lot of this comes in into the form of policymakers’ credibility.

(00:59:33):

Now, the UK, for example, has lost quite a lot of it because from a fiscal perspective, they just are doing the opposite of the market once at this point, which is they’re being expensive. Now, if you look at other countries like Switzerland, for example, Switzerland has a gigantic amount of dollar reserves and they’ve invested in Apple. I mean, they’ve invested in the Nasdaq, in the stock market. They had so many that they had to buy a large amount of foreign assets, which also means that if they wanted to defend their local currency, Rebecca, the Swiss Frank, they could just sell as many dollars as they want because they have an abundant amount on excess reserves. They have a very credible policymaking. So it’s not a one size fit all out there, and that’s one of the most interesting parts of the 2022 markets is that macro is back.

(01:00:21):

You need to look at fundamentals. You need to do your analysis, and we have been used between 2010 and 2020 to basically buy some assets and make money out of it. All of a sudden now, it’s more about studying what are the underlying drivers of different asset classes, of different currencies, of different countries.

Rebecca Hotsko (01:00:38):

Last thing, if you could leave our audience with one practical takeaway on how to maybe position theirselves during this time, what would you say?

Alfonso Peccatiello (01:00:48):

I would say that, at least I would say what I do right now, which is visible on The Macro Compass. By the way, it’s all public and free. I’ve been extremely defensive in the positioning this year. It’s been mostly dollar cash. I am lucky to be in Europe from this perspective, which means that simply moving my bank deposits from euro to dollar has been a pretty decent tailwind for performance, but most importantly, I’ve been extremely reluctant in engaging in any meaningful risk taking activity, be in the equity market, be in the bond market. The reason is, Rebecca, as we described, we are in a situation where the amount of money for the private sector on a rate of change basis is going down, the amount of money for the financial sector, so bank reserves, is also going down on a rate of change basis.

(01:01:33):

The economy is slowing down and I don’t think that analysts have yet reflected the drawdown we’re going to be seeing in earnings, the drawdown we’re going to be seeing in weakness in the labor market. It’s not yet being reflected in earning pressure expectations next year, for example. We still leave a little bit on this fairy tale of a soft lending, which should overleverage the economy facing a double tightening from a monetary perspective, financial money and real economy money at the same time. I don’t think it’s very well-equipped for a soft landing.

(01:02:03):

Right now, I would still be pretty defensive. I would still be patient. We haven’t seen yet the earning per share bear market, let’s say. As always, for a long-only investor, this is the most tricky period of all. There is basically no place where to hide at the moment. It requires patience and discipline, but macro is also made of cycles, and we have been used for 10 years to see basically no cycles, that we have been used to see risk assets rally. We have been used to see central bankers backstopping any selloff. Well, I would say that environment is not here with us anymore and we need to be more selective, more nimble, and more used to be patient, disciplined, and look at cycles.

Rebecca Hotsko (01:02:45):

That was so great. Thank you so much, Alfonso. Before we close out today, where can the audience go to read your articles, learn more about you, and connect with you?

Alfonso Peccatiello (01:02:56):

Yeah. So the easiest way would be to sign up the free newsletter. There is no charge. It’s called The Macro Compass. It’s on Substack. So the link will be themacrocompass.substack.com, and it’s a community of I think more than a hundred thousand people now. So thank you to all people reading my pieces. It goes out once a week, and it basically tries to apply my macroeconomic framework across asset classes, looking at a bunch of indications from macro to central banking, to anything that can move and influence cross asset performance, and then it translates those analysis into practical portfolio allocation, both for a long-only investor and for a more tactical investor, which is maybe more interested in long-short positioning. It goes out once a week. It’s free of charge. So that’s the easiest way to get in touch with me and my ideas. The second one will probably be Twitter, I think, where I’m relatively active at the Twitter handle, @MacroAlf.

Rebecca Hotsko (01:03:54):

Perfect. I will make sure to link both of those in the show notes. I’ve definitely been enjoying reading your newsletter, so I’ll link that below. Thank you so much again, Alfonso.

Alfonso Peccatiello (01:04:04):

Thanks, Rebecca. You’ve been an incredible host. Thank you.

Rebecca Hotsko (01:04:08):

All right. I hope you enjoyed today’s episode. Make sure to subscribe to the show on your favorite podcast app so that you never miss a new episode. If you’ve been enjoying the podcast, I’d really appreciate it if you left us a rating or a review. This really helps support us and is the best way to help new people discover the show, and if you haven’t already, be sure to check out our website, theinvestorspodcast.com. There’s a ton of useful educational resources on there, as well as our TIP Finance tool, which is a great tool to help you manage your own stock portfolio. With that, I will see you again next time.

Outro (01:04:45):

Thank you for listening to TIP. Make sure to subscribe to We Study Billionaires by The Investor’s Podcast Network. Every Wednesday, we teach you about Bitcoin, and every Saturday, we study billionaires and the financial markets. To access our show notes, transcripts or courses, go to theinvestorspodcast.com. This show is for entertainment purposes only. Before making any decision, consult a professional. This show is copyrighted by The Investor’s Podcast Network. Written permission must be granted before syndication or rebroadcasting.